APR vs EAR: Why the Difference Matters

When comparing loans, you will encounter two different numbers that both describe the yearly cost of borrowing: APR (Annual Percentage Rate) and EAR (Effective Annual Rate). They sound similar but can differ substantially. Understanding this difference can save you thousands of dollars over the life of a loan.

What is APR?

The APR is a regulatory disclosure designed to make loan comparison easier. It expresses the cost of borrowing as a yearly rate, but it starts from the nominal (stated) interest rate, not the actual effective rate.

The nominal rate is simply divided by the number of compounding periods per year. For a loan with a 12% nominal annual rate and monthly compounding:

periodic rate = 0.12 / 12 = 0.01 (1% per month)

But this ignores the fact that interest in month 2 is calculated on a balance that already includes month 1 interest. After 12 months of 1% monthly compounding, the true annual cost is higher than 12%.

What is EAR?

The EAR (sometimes called the APY, or Annual Percentage Yield) accounts for the compounding effect within the year. It answers the question: what is the actual yearly cost, including compounding?

EAR = (1 + nominal rate / periods)periods − 1

For the 12% nominal rate with monthly compounding:

EAR = (1 + 0.12 / 12)12 − 1 = 0.1268 (12.68%)

This 0.68% difference may seem small, but it compounds over a 30-year mortgage into meaningful extra interest paid.

Which rate should you use?

For the annuity formula that underlies French amortization, EAR is the correct rate. The formula assumes effective periodic rates, and using the nominal APR divided by periods introduces a systematic error in the calculated payment.

When comparing loan offers, always ask for the EAR and use it in your calculations.